An investor's guide to getting what you don't pay for

Be sure to frame exactly what you’re looking at when you look for investing answers. (Flickr)

Cost is important – especially for big-ticket purchases. If you were looking to make a major purchase and you had to choose between two options that were broadly similar, I suspect that a major element of the decision-making process would involve a determination revolving around how much the options cost. That’s just natural. Seeing as that is the case, here are some questions for you:

What amount of concern would you have if I told you one option cost 1 percentage point more than another?
What amount of concern would you have if I told you one option cost 5 times more than the other?
What if I told you I was asking the exact same question, only framing it differently?

Let’s say the big-ticket item in question is how much you’ll be paying over the course of your lifetime for access to a broadly-diversified investment portfolio that is customized to your needs and circumstances? Intrepid puzzle-solvers would quickly realize that the costs for the two options are fairly obvious: 0.25% and 1.25%. The second option is simultaneously 1 point higher and 5 times higher.

Now take a moment to reflect on your intuitive answers to the first two questions. Most people would say that a 1% difference is a rounding error. If you were looking to buy a new car and one cost $30,000 and the other cost $30,300, I doubt that the $300 difference on the margin would play much of a role in your decision-making. In other words, a 1% difference sounds like something that is all but inconsequential. Obviously, if you were looking to buy a car for $30,000 and the alternative option was a car that cost $150,000, that would be an extremely material consideration for all but the very wealthiest of people.

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At issue here is a concern that behavioural economists call “framing”. Framing is simply a term that means we make decisions based largely on how the question was put to us. Using the same facts, but framing them differently can lead to very different outcomes. Is the glass half full or half-empty?

When it comes to personal finance, the distinction can be critical. Most people have no idea that, in a world where investment management is largely commoditized (i.e. where virtually all investment products are similarly good or bad), the major differentiator is cost. As a result, substituting products that cost 0.25% in in exchange for incumbent products that cost 1.25% can have an enormous difference over your lifetime.

Please don’t take my word for it. Go to an online calculator and plug in a few simple numbers:

How much money you have today
How much more money you’ll be saving annually
Your expected rate of return
Your time horizon (this should be in years and assuming normal life expectancy – say to age 85). A 50-year-old might have a 35-year time horizon

Now, do the same exercise a second time, only this time, change the assumed number in question #3 by making it 1% lower (to account for products that cost 1% more). The 1% difference in predictable product cost will almost certainly have a major (usually six-digit) impact on most people’s outcome differential. There are lots of pithy little ways to summarize the lesson: Cost matters. A penny saved is a penny earned. You get what you don’t pay for.

The lesson in this little thought exercise is that most people significantly underestimate the impact of product cost because they look at it from the jumping off point of a 1% difference being small. However, if long-term return expectations are (say) between 2.3% and 4.6% above inflation and inflation runs at 2%, then the difference in outcomes can become extremely material.

Conservative investors might be looking at returns of 4.3% vs. 3.3% and aggressive investors might be looking at a differential of 6.6% vs. 5.6%. Framed this way, avoidable excess product cost eats away at anywhere from 15% to 30% of your full annual expected growth. If you’re not getting any additional expected value, why would you pay the additional cost?

John De Goey is a portfolio manager with Industrial Alliance Securities Inc. and the author of The Professional Financial Advisor IV. Industrial Alliance Securities Inc. is a member of the Canadian Investor Protection Fund. The opinions expressed herein are those of Mr. De Goey alone and may not be aligned with the opinions and values of Industrial Alliance Securities Inc. or any of its affiliated companies.

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